June 6, 2011

Disaster Not Averted

When the financial system was on the edge of melting down back in the fall of 2008, there was much talk in the punditocracy of a second Great Depression. The story was that we risked repeating the mistake at the onset of the first Great Depression: allowing a cascade of bank failures that both destroyed much of the country’s wealth and left the financial system badly crippled. Instead, however, we acted, and these days the accepted wisdom is that the TARP and other special lending facilities created by the Federal Reserve Board prevented a similar collapse that saved us from a second Great Depression. But this view badly misunderstands the nature of the first Great Depression—and may, in fact, result in the country suffering the second Great Depression that the pundits claim we have averted.

Allowing the cascade of financial collapses at the start of the first Great Depression was a mistake. However, there was nothing about this initial collapse that necessitated the decade of double-digit unemployment that was the central tragedy of the Great Depression. This was the result of the failure of the federal government to respond with sufficient vigor to mass unemployment. Indeed, the economy only broke out of the Depression when the federal government undertook massive deficit spending to fight World War II. Deficits peaked at more than 25 percent of GDP. This would be the equivalent, in today’s economy, of running annual deficits of $4 trillion.

There was no economic reason that the government could not have spent on this scale in 1931, as opposed to 1941; the obstacles were political. Then, as now, politicians in Washington were obsessed with the budget deficit. They never would have countenanced such spending, apart from the threat to the nation posed by Hitler and the Axis powers. The New Deal deficit spending helped boost the economy and bring the unemployment rate down to single-digit levels, but fear of deficits limited the scale of New Deal programs and caused Roosevelt to reverse course and cut back on spending in 1937, just as the economy was gaining momentum.

Unfortunately, the country seems destined to follow the same course in the current slump as it did in the 30s. The May jobs report should have provided the sort of stiff kick that is needed to revive discussion of additional stimulus. Instead, it seems to have barely shaken Washington’s ongoing obsession with deficits.

In policy circles, there seems to be an absurd faith that demand in the economy will arise out of nowhere if we are just virtuous enough in reducing the deficit. That is not the way the economy works. Demand must come from some discrete source and it is very difficult to see where that might be if the country continues on a path of deficit reduction.

To see why this is the case, first note that nearly 70 percent of demand in our economy is from consumption, but consumption has been growing slowly for two reasons. The first is that the economy has been creating few jobs. Furthermore, in a weak labor market workers do not have the bargaining power to push up their wages. The slow growth in jobs and stagnant wages mean that most families, who get nearly all their income from working, are seeing little growth in income. Slow growth in income means slow growth in consumption.

The second factor depressing consumption has been the continuing deflation of the housing bubble. To date, the decline in house prices has destroyed nearly $7 trillion in housing equity. And prices are still falling. Homeowners are likely to see another $1 trillion in equity disappear over the next year. The loss of this wealth will lead homeowners to cut back their consumption further in order to rebuild their savings.

Beyond the decline in consumption, the overbuilding in both residential and non-residential real estate during the bubble years ensures that construction will also remain weak at least through 2012. Firms could invest more in equipment and software, but this component of the economy is already surprisingly strong. This type of investment is close to its pre-recession level, in spite of the fact that most industries have large amounts of excess capacity.

Trade could also provide a boost, but this would require either extraordinarily rapid growth in demand from our trading partners or a sharp decline in the dollar that would make our goods more competitive. With most of our major trading partners also mired in stagnation, a rescue by fast-growing trading partners can be ruled out. Similarly, a lower-valued dollar is providing some benefits, but not of the magnitude needed to restore the economy to anything close to full employment.

With these other sectors accounted for, this leaves the government as the only remaining candidate for boosting the economy. But additional stimulus is not even on the agenda in Washington. Instead, we are seeing cutbacks at all levels of government. These cutbacks led to a loss of 29,000 jobs in May. The pace of job loss is only likely to increase when states impose another round of cuts on July 1, the beginning of a new fiscal year for most of them.

All of this suggests a bleak picture for the unemployed. The economy must create 90,000 jobs a month just to keep even with the growth of the labor force. To be sure, the dismal 54,000 job performance for May was partly an issue of timing, with jobs showing up in April instead of May. But even taking the last three months together yields an average growth rate of just 160,000. At this pace, it would take more than a decade to get back to normal levels of unemployment.

Moreover, there are more factors pointing to slower growth than faster growth going forward. In addition to the state and local cuts kicking in next month, the new fiscal year for the federal government begins October 1. This is also likely to involve further cuts in spending. And the payroll tax cut is scheduled to end 3 months later, as is the extension of unemployment benefits. At some point, the pain of high unemployment across the country may lead to some new thinking in Washington, but until that time, welcome to the second Great Depression.